Beta

 The standard procedure for estimating betas is to regress stock returns (R j ) against market returns (R m ): R j = a + b R m where a is the intercept and b is the slope of the regression.  The slope of the regression corresponds to the beta of the stock, and measures the riskiness of the stock. Estimating Beta

 The intercept of the regression provides a simple measure of performance during the period of the regression, relative to the capital asset pricing model. Rj = Rf + b (Rm - Rf) = Rf (1-b) + b Rm Capital Asset Pricing Model Rj = a + b Rm Regression Equation Estimating Performance

 If a > Rf (1-b)....Stock did better than expected during regression period a = Rf (1-b)....Stock did as well as expected during regression period a < Rf (1-b)....Stock did worse than expected during regression period  The difference between the intercept and Rf (1-b) is Jensen's alpha. If it is positive, your stock did perform better than expected during the period of the regression. Estimating Performance

The R squared (R 2 ) of the regression provides an estimate of the proportion of the risk (variance) of a firm that can be attributed to market risk. The balance (1 - R 2 ) can be attributed to firm specific risk. Firm Specific and Market Risk

 Decide on an estimation period  Services use periods ranging from 2 to 5 years for the regression  Longer estimation period provides more data, but firms change.  Shorter periods can be affected more easily by significant firm-specific event that occurred during the period (Example: ITT for )  Decide on a return interval - daily, weekly, monthly  Shorter intervals yield more observations, but suffer from more noise.  Noise is created by stocks not trading and biases all betas towards one. Setting up for the Estimation

 Estimate returns (including dividends) on stock  Return = (PriceEnd - PriceBeginning + DividendsPeriod)/ PriceBeginning  Included dividends only in ex-dividend month  Choose a market index, and estimate returns (inclusive of dividends) on the index for each interval for the period. Setting up for the Estimation

Period used: 5 years Return Interval = Monthly Market Index: S&P 500 Index. For instance, to calculate returns on Disney in December 2004, –Price for Disney at end of November 2004 = $ –Price for Disney at end of December 2004 = $ –Dividends during month = $0.237 (It was an ex-dividend month) –Return =($ $ $ 0.237)/$26.52= 4.33% Choosing the Parameters: Disney

To estimate returns on the index in the same month –Index level at end of November 2004 = –Index level at end of December 2004 = –Dividends on index in December 2004 = –Return =( – )/ = 3.25% Choosing the Parameters:

Disney’s Historical Beta

Using monthly returns from 2004 to 2008, we ran a regression of returns on Disney stock against the S&P 500. The output is below: –Returns Disney = 0.47% Returns S & P 500 (R 2 =41%) (0.16) The Regression Output

Intercept = 0.47% –This is an intercept based on monthly returns. Thus, it has to be compared to a monthly riskfree rate over the regression period (not today’s numbers). –Between 2004 and 2008 Average Annualized T.Bill rate = 3.27% Monthly Riskfree Rate = 0.272% (=3.27%/12) Riskfree Rate (1-Beta) = 0.272% (1-0.95) = 0.01% Analyzing Disney’s Performance

The Comparison is then between What you expected to makeWhat you actually made –InterceptversusRiskfree Rate (1 - Beta) –0.47%versus0.01% –Jensen’s Alpha = 0.47% -0.01% = 0.46% Disney did 0.46% better than expected, per month, between 2004 and –Annualized, Disney’s annual excess return = (1.0046)12-1= 5.62% Analyzing Disney’s Performance

If you did this analysis on every stock listed on an exchange, what would the average Jensen’s alpha be across all stocks? –Depend upon whether the market went up or down during the period –Should be zero –Should be greater than zero, because stocks tend to go up more often than down More on Jensen’s Alpha

Disney has a positive Jensen’s alpha of 5.62% a year between 2004 and This can be viewed as a sign that management in the firm did a good job, managing the firm during the period. –True –False A positive Jensen’s alpha… Who is responsible?

Slope of the Regression of 0.95 is the beta Regression parameters are always estimated with error. The error is captured in the standard error of the beta estimate, which in the case of Disney is Assume that I asked you what Disney’s true beta is, after this regression. –What is your best point estimate? –What range would you give me, with 67% confidence? –What range would you give me, with 95% confidence? Estimating Disney’s Beta

The Dirty Secret of “Standard Error” Distribution of Standard Errors: Beta Estimates for U.S. stocks < >.75 Standard Error in Beta Estimate Number of Firms

R Squared = 41% This implies that –41% of the risk at Disney comes from market sources –59%, therefore, comes from firm-specific sources The firm-specific risk is diversifiable and will not be rewarded Breaking down Disney’s Risk

You are a diversified investor trying to decide whether you should invest in Disney or Amgen. They both have betas of 0.95, but Disney has an R Squared of 41% while Amgen’s R squared of only 20.5%. Which one would you invest in? –Amgen, because it has the lower R squared –Disney, because it has the higher R squared –You would be indifferent Question

Would your answer be different if you were an undiversified investor? Question

Beta Estimation: Using a Service (Bloomberg)

Inputs to the expected return calculation –Disney’s Beta = 0.95 –Riskfree Rate = 3.50% (U.S. ten-year T.Bond rate in May 2009) –Risk Premium = 6% (Based on updated implied premium at the start of 2009) Expected Return = Riskfree Rate + Beta (Risk Premium) = 3.50% (6.00%) = 9.2% Estimating Expected Returns for Disney in May 2009

 As a potential investor in Disney, what does this expected return of 9.2% tell you?  This is the return that I can expect to make in the long term on Disney, if the stock is correctly priced and the CAPM is the right model for risk,  This is the return that I need to make on Disney in the long term to break even on my investment in the stock  Both Question

 Assume now that you are an active investor and that your research suggests that an investment in Disney will yield 12.5% a year for the next 5 years. Based upon the expected return of 9.2%, you would  Buy the stock  Sell the stock Question

Managers at Disney –need to make at least 9.2% as a return for their equity investors to break even. –this is the hurdle rate for projects, when the investment is analyzed from an equity standpoint In other words, Disney’s cost of equity is 9.2%. What is the cost of not delivering this cost of equity? How managers use this expected return

You are advising a very risky software firm on the right cost of equity to use in project analysis. You estimate a beta of 3.0 for the firm and come up with a cost of equity of 21.5%. The CFO of the firm is concerned about the high cost of equity and wants to know whether there is anything he can do to lower his beta. How do you bring your beta down? Question

Should you focus your attention on bringing your beta down? –Yes –No Question

Disney’s Beta Calculation: An Updated Value!! Jensen’s alpha = 0.33% - (2%/52) (1 – 1.08) = 0.34% Annualized = ( )^52-1 = 19.30% This is a weekly regression

Regression Diagnostics for Tata Chemicals Beta = % range Jensen’s  = -0.44% - 5%/12 (1-1.18) = -0.37% Annualized = ( ) 12 -1= % 56% market risk 44% firm specific Expected Return = Riskfree Rate+ Beta*Risk premium = 4% (6%+4.51%) = 19.40%

Beta Estimation and Index Choice: Deutsche Bank

The R squared for Deutsche Bank is very high (67%). Why is that? The beta for Deutsche Bank is –Is this an appropriate measure of risk? –If not, why not? If you were an investor in primarily U.S. stocks, would this be an appropriate measure of risk? A Few Questions

Deutsche Bank: Alternate views of Risk

Aracruz’s Beta?

Beta: Exploring Fundamentals

Industry Effects: The beta value for a firm depends upon the sensitivity of the demand for its products and services and of its costs to macroeconomic factors that affect the overall market. –Cyclical companies have higher betas than non-cyclical firms –Firms which sell more discretionary products will have higher betas than firms that sell less discretionary products Determinant 1: Product Type

 Phone service is close to being non-discretionary in the United States and Western Europe. However, in much of Asia and Latin America, there are large segments of the population for which phone service is a luxury.  Which of the following is true?  Emerging market telecom companies should have higher betas than developed market telecom companies.  Developed market telecom companies should have higher betas than emerging market telecom companies  Betas should be similar Question

Operating leverage refers to the proportion of the total costs of the firm that are fixed. Other things remaining equal, higher operating leverage results in greater earnings variability which in turn results in higher betas. Determinant 2: Operating Leverage Effects

Fixed Costs Measure = Fixed Costs / Variable Costs –This measures the relationship between fixed and variable costs. The higher the proportion, the higher the operating leverage. Measures of Operating Leverage

EBIT Variability Measure = % Change in EBIT / % Change in Revenues –This measures how quickly the earnings before interest and taxes changes as revenue changes. The higher this number, the greater the operating leverage. Measures of Operating Leverage

Disney’s Operating Leverage:

Operating Leverage = % Change in EBIT/ % Change in Sales = 13.26% / 13.73% = 0.97 This is lower than the operating leverage for other entertainment firms, which we computed to be This would suggest that Disney has lower fixed costs than its competitors. The acquisition of Capital Cities by Disney in 1996 may be skewing the operating leverage. Looking at the changes since then: –Operating Leverage = 11.72%/9.91% = 1.18 –Looks like Disney’s operating leverage has increased since In fact, it is higher than the average for the sector. Reading Disney’s Operating Leverage

As firms borrow, they create fixed costs (interest payments) that make their earnings to equity investors more volatile. This increased earnings volatility which increases the equity beta. Determinant 3: Financial Leverage

The beta of equity alone can be written as a function of the unlevered beta and the debt- equity ratio  L =  u (1+ ((1-t)D/E)) where –  L = Levered or Equity Beta –  u = Unlevered or Asset Beta –t = Marginal tax rate –D = Market Value of Debt –E = Market Value of Equity Equity Betas and Leverage

The regression beta for Disney is This beta is a levered beta (because it is based on stock prices, which reflect leverage) and the leverage implicit in the beta estimate is the average market debt equity ratio during the period of the regression (2004 to 2008) Effects of leverage on betas: Disney

The average debt equity ratio during this period was 24.64%. The unlevered beta for Disney can then be estimated (using a marginal tax rate of 38%) –= Current Beta / (1 + (1 - tax rate) (Average Debt/Equity)) –= 0.95 / (1 + ( )(0.2464))= Effects of leverage on betas: Disney

Disney : Beta and Leverage

The beta of a portfolio is always the market- value weighted average of the betas of the individual investments in that portfolio. –the beta of a mutual fund is the weighted average of the betas of the stocks and other investment in that portfolio –the beta of a firm after a merger is the market-value weighted average of the betas of the companies involved in the merger. Betas are weighted Averages

The Disney/Cap Cities Merger: Pre-Merger

Calculate the unlevered betas for both firms –Disney’s unlevered beta = 1.15/(1+0.64*0.10) = 1.08 –Cap Cities unlevered beta = 0.95/(1+0.64*0.03) = 0.93 Calculate the unlevered beta for the combined firm –Unlevered Beta for combined firm = 1.08 (34286/53401) (19115/53401) = –The weights used are the firm values (and not just the equity values) of the two firms, since these are unlevered betas and thus reflects the risks of the entire businesses and not just the equity] Disney Cap Cities Beta Estimation: Step 1

 If Disney had used all equity to buy Cap Cities equity, while assuming Cap Cities debt, the consolidated numbers would have looked as follows:  Debt = $ 3,186+ $615 = $ 3,801 million  Equity = $ 31,100 + $18,500 = $ 49,600 m (Disney issues $18.5 billion in equity)  D/E Ratio = 3,801/49600 = 7.66%  New Beta = ( (.0766)) = 1.08 Disney Cap Cities Beta Estimation: Step 2

 Since Disney borrowed $ 10 billion to buy Cap Cities/ABC, funded the rest with new equity and assumed Cap Cities debt:  The market value of Cap Cities equity is $18.5 billion. If $ 10 billion comes from debt, the balance ($8.5 billion) has to come from new equity.  Debt = $ 3,186 + $615 million + $ 10,000 = $ 13,801 million  Equity = $ 31,100 + $8,500 = $39,600 million  D/E Ratio = 13,801/39600 = 34.82%  New Beta = ( (.3482)) = 1.25 Disney Cap Cities Beta Estimation: Step 2

Firm Betas as weighted averages: The beta of a firm is the weighted average of the betas of its individual projects. Firm Betas and Business betas: At a broader level of aggregation, the beta of a firm is the weighted average of the betas of its individual division. Firm Betas versus divisional Betas

The top-down beta for a firm comes from a regression The bottom up beta can be estimated by doing the following: –Find out the businesses that a firm operates in –Find the unlevered betas of other firms in these businesses –Take a weighted (by sales or operating income) average of these unlevered betas –Lever up using the firm’s debt/equity ratio Bottom-up versus Top-down Beta

The bottom up beta is a better estimate than the top down beta for the following reasons –The standard error of the beta estimate will be much lower –The betas can reflect the current (and even expected future) mix of businesses that the firm is in rather than the historical mix Bottom-up versus Top-down Beta

BusinessComparable firms Number of firms Median levered beta Median D/E Unlevered beta Median Cash/Firm Value Unlevered beta corrected for cash Media Networks Radio and TV broadcasting companies -US % % Parks and Resorts Theme park & Resort companies - Global % % Studio Entertainment Movie companies - US % % Consumer ProductsToy companies- US % % Disney’s business breakdown

A closer look at the process… Studio Entertainment Betas

Estimate the bottom up unlevered beta for Disney’s operating assets. Step 1: Start with Disney’s revenues by business (next slide). Step 2: Estimate the value as a multiple of revenues by looking at what the market value of publicly traded firms in each business is, relative to revenues. EV/Sales = Disney’s bottom up beta

Step 3: Multiply the revenues in step 1 by the industry average multiple in step 2. Disney has a cash balance of $3,795 million. If we wanted a beta for all of Disney’s assets (and not just the operating assets), we would compute a weighted average: Disney’s bottom up beta

Step 1: Allocate debt across businesses Step 2a: Compute levered betas and costs of equity for Disney’s operating businesses. Step 2b: Compute the cost of equity for all of Disney’s assets: –Equity Beta Disney as company = (1 + (1 – 0.38)(0.3691)) = Disney’s Cost of Equity Riskfree Rate = 3.5% Risk Premium = 6%

Assume now that you are the CFO of Disney. The head of the movie business has come to you with a new big budget movie that he would like you to fund. He claims that his analysis of the movie indicates that it will generate a return on equity of 12%. Would you fund it? –Yes. It is higher than the cost of equity for Disney as a company –No. It is lower than the cost of equity for the movie business. –What are the broader implications of your choice? Discussion Issue

The beta for emerging market paper and pulp companies of 1.01 was used as the unlevered beta for Aracruz. When computing the levered beta for Aracruz’s paper and pulp business, we used the gross debt outstanding of 9,805 million BR and the market value of equity of 8907 million BR, in conjunction with the marginal tax rate of 34% for Brazil: –Gross Debt to Equity ratio = Debt/Equity = 9805/8907 = % –Levered Beta for Aracruz Paper business = 1.01 (1+(1-.34)(1.1008)) = 1.74 Estimating Aracruz’s Bottom Up Beta Bottom up Betas for Paper & Pulp

We will use a risk premium of 9.95% in computing the cost of equity, composed of the mature market equity risk premium (6%) and the Brazil country risk premium of 3.95% (estimated earlier). U.S. $ Cost of Equity –Cost of Equity = 10-yr T.Bond rate + Beta * Risk Premium –= 3.5% (9.95%) = 20.82% To convert to a Nominal $R Cost of Equity –Cost of Equity = = (1.07/1.02) -1 =.2675 or 26.75% –Alternatively, you could just replace the riskfree rate with a nominal $R riskfree rate, but you would then be keeping risk premiums which were computed in dollar terms fixed while moving to a higher inflation currency. Aracruz: Cost of Equity Calculation

Unlevered betas for Tata Chemical’s Businesses –Based upon betas of emerging market companies, The bottom up beta for Tata Chemicals

Cost of Equity –Rupee Riskfree rate =4%; Indian ERP = 6% % The bottom up beta for Tata Chemicals

Deutsche Bank is in two different segments of business - commercial banking and investment banking. –To estimate its commercial banking beta, we will use the average beta of European commercial banks. –To estimate the investment banking beta, we will use the average beta of investment banks (primarily US and UK based). –The weights are based on revenues in each division. To estimate the cost of equity in Euros, we will use the German 10-year bond rate of 3.6% as the riskfree rate and the 6% as the mature market premium. Estimating Bottom-up Beta: Deutsche Bank

The conventional approaches of estimating betas from regressions do not work for assets that are not traded. There are no stock prices or historical returns that can be used to compute regression betas. There are two ways in which betas can be estimated for non-traded assets –Using comparable firms –Using accounting earnings Estimating Betas for Non-Traded Assets

Using comparable firms to estimate beta for Bookscape

Because the debt/equity ratios used in computing levered betas are market debt equity ratios, and the only debt equity ratio we can compute for Bookscape is a book value debt equity ratio, we have assumed that Bookscape is close to the book industry median debt to equity ratio of percent. Estimating Bookscape Levered Beta and Cost of Equity

Using a marginal tax rate of 40 percent for Bookscape, we get a levered beta of –Levered beta for Bookscape = 1.02 [1 + (1 – 0.40) (0.5347)] = 1.35 Using a riskfree rate of 3.5% (US treasury bond rate) and an equity risk premium of 6%: –Cost of Equity = 3.5% (6%) = 11.60% Estimating Bookscape Levered Beta and Cost of Equity

Using Accounting Earnings to Estimate Beta

Regressing the changes in equity earnings at Bookscape against changes in equity earnings for the S&P 500 yields the following: –Bookscape Earnings Change = (S&P 500 Earnings Change) –Based upon this regression, the beta for Bookscape’s equity is –Using changes in operating earnings for both the firm and the S&P 500 should yield the equivalent of an unlevered beta. The cost of equity based upon the accounting beta is: – Cost of equity = 3.5% (6%) = 8.42% The Accounting Beta for Bookscape

Beta measures the risk added on to a diversified portfolio. The owners of most private firms are not diversified. Therefore, using beta to arrive at a cost of equity for a private firm will –Under estimate the cost of equity for the private firm –Over estimate the cost of equity for the private firm –Could under or over estimate the cost of equity for the private firm Is Beta an Adequate Measure of Risk for a Private Firm?

Adjust the beta to reflect total risk rather than market risk. This adjustment is a relatively simple one, since the R squared of the regression measures the proportion of the risk that is market risk. – Total Beta = Market Beta / Correlation of the sector with the market Total Risk versus Market Risk

In the Bookscape example, where the market beta is 1.35 and the average R- squared of the comparable publicly traded firms is 21.58%; the correlation with the market is 46.45%. –Total Cost of Equity = 3.5% (6%) = 20.94% Total Risk versus Market Risk